T.C. Memo. 1999-339
UNITED STATES TAX COURT
PELTON & GUNTHER, PROFESSIONAL CORPORATION, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 23914-97. Filed October 8, 1999.
Jon L. Brown, for petitioner.
Margaret S. Rigg, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
GERBER, Judge: Respondent determined an $81,679 income tax
deficiency for petitioner’s tax year ended May 31, 1993, a $6,082
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section 6651(a)(1)1 addition to tax, and a $16,366 section 6662
penalty.
The issues for our consideration are: (1) Whether
litigation costs paid by petitioner on behalf of clients and then
reimbursed to petitioner are deductible as ordinary and necessary
business expenses or whether such payments are in the nature of
nondeductible advances or loans; (2) whether respondent’s
adjustment to petitioner’s reporting of litigation costs triggers
a section 481 adjustment; (3) whether petitioner’s 1990 and 1991
net operating losses may be carried forward to the 1993 tax year,
without first being applied to years prior to 1990 and 1991; and
(4) whether petitioner is liable for an accuracy-related penalty
under section 6662(a).2 For convenience and continuity, separate
fact findings and opinion portions are set forth for each issue
decided by the Court.3
1
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the year under
consideration, and Rule references are to this Court’s Rules of
Practice and Procedure.
2
Petitioner conceded at trial that if the Court determined
that there was a deficiency, then it would be liable for the sec.
6651(a)(1) addition to tax for filing a delinquent return.
3
The parties’ stipulated facts and exhibits are
incorporated by this reference.
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I. Advanced Litigation Costs
FINDINGS OF FACT
Petitioner Pelton & Gunther, P.C. (P&G), is a law firm
operating as a professional corporation and had its principal
place of business in San Mateo, California, at the time the
petition was filed. P&G’s Federal income tax returns are filed
for fiscal years ending May 31. For the taxable years ended May
31, 1992 and 1993, P&G used the cash method of accounting for
Federal income tax reporting.
P&G’s legal specialty is the defense of personal injury
automobile accident lawsuits. More than 90 percent of P&G’s
services were performed pursuant to the request of the California
State Automobile Association (CSAA). At CSAA’s request, P&G
provided legal services for CSAA policyholders in connection with
controversies arising from automobile accidents. Under this
arrangement, CSAA generally paid P&G $400 at the time P&G was
asked to represent one of CSAA’s policyholders. P&G would pay
various litigation costs including filing fees; deposition
expenses; the costs of medical records; fees for witnesses, court
reporters, and interpreters; and similar expenses as they would
occur. The litigation costs P&G paid on each case, more often
than not, exceeded $400.
P&G would bill CSAA for its legal services and the
litigation costs that it incurred on behalf of CSAA’s
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policyholders after the controversies were resolved and the cases
were closed. Cases were often open for more than 1 year. Some
bills from P&G to CSAA were for litigation costs only, some were
for legal fees (services) only, and some were for both costs and
fees. P&G’s fees were paid by CSAA at a stated hourly rate. P&G
claimed as a deduction litigation costs it paid on behalf of
CSAA’s policyholders, either from the $400 retainer or as
advances, in the year that it paid the litigation costs. P&G
reported the $400 retainers and the reimbursements of litigation
costs as income in the year they were received by P&G.
P&G’s deductions for litigation costs were as follows:
Fiscal year ending Litigation costs
May 31, 1990 $262,771.60
May 31, 1991 280,332.39
May 31, 1992 382,365.84
May 31, 1993 358,092.07
May 31, 1994 254,562.73
P&G reported retainers and reimbursed litigation
costs as income as follows:
Retainers and reimbursed
Fiscal year ending litigation costs
May 31, 1991 $242,867.08
May 31, 1992 361,880.37
May 31, 1993 377,767.17
May 31, 1994 276,686.05
Respondent, in the notice of deficiency, disallowed a
portion of the total deduction petitioner claimed for litigation
costs, reduced income by the amount of reimbursed previously
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claimed deductions that P&G had included in its 1993 fiscal year,
and made a section 481 adjustment that again caused the
reimbursed prior year costs to be included in P&G’s income for
its 1993 fiscal year. The section 481 adjustment had the effect
of reversing respondent’s adjustment backing out petitioner’s
inclusion of the prior year costs that were reimbursed during the
1993 fiscal year.
OPINION
Section 162 permits the deduction of ordinary and necessary
expenses incurred in carrying on a trade or business. P&G
contends that the litigation costs it paid on behalf of clients
were ordinary and necessary expenses of its law practice.
Respondent, on the other hand, contends that, in essence, the
payments were in the nature of loans to P&G’s clients because P&G
paid the litigation costs with the understanding that it would be
reimbursed by CSAA.
We agree with respondent. On the basis of longstanding case
precedents, P&G’s payments or advances of the client’s litigation
costs should be treated like loans. See Canelo v. Commissioner,
53 T.C. 217 (1969), affd. per curiam 447 F.2d 484 (9th Cir.
1971); see also Herrick v. Commissioner, 63 T.C. 562 (1975).
Canelo v. Commissioner, supra, involved a law firm which
primarily engaged in plaintiffs’ personal injury litigation on a
contingent fee basis. The firm advanced the clients’ litigation
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costs, and the clients were obligated to repay the advances only
in the event of a favorable settlement or judgment. Accordingly,
if nothing was recovered, the client would have no obligation.
In Canelo, prospective clients were screened and were accepted
only if there were good prospects for recovery. In holding that
the advanced costs constituted loans and not deductible expenses,
the Court emphasized that “If expenditures are made with the
expectation of reimbursement, it follows that they are in the
nature of loans, notwithstanding the absence of formal
indebtedness.” Id. at 225.
In this case, we note that the repayment of the advances was
in no way contingent upon the outcome of the underlying
litigation. P&G expected to be and was repaid for all costs
advanced to CSAA’s policyholders. “It has been firmly
established that where a taxpayer makes expenditures under an
agreement that he will be reimbursed therefor, such expenditures
are in the nature of loans or advancements and are not deductible
as business expenses.” Patchen v. Commissioner, 27 T.C. 592, 600
(1956), affd. in part and revd. in part on other grounds 258 F.2d
544 (5th Cir. 1958).
Petitioner relies on Boccardo v. Commissioner, 56 F.3d 1016
(9th Cir. 1995), revg. T.C. Memo. 1993-224, in support of the
contention that its advances on behalf of clients were ordinary
and necessary expenses of the law practice. That case is
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factually distinguishable because the Boccardo law firm received
a flat percentage (gross fee arrangement) of the client’s
recovery. The Boccardo law firm was entitled to the fee if the
client recovered, but it was not entitled to reimbursement of the
litigation costs “off the top” or before computing its percentage
fee. By contrast, a net fee arrangement would normally permit
reimbursement of the costs before computing the percentage fee.
P&G’s fee arrangement did not involve either a gross or net fee
arrangement. P&G’s fee, which was paid by CSAA, was billed at a
stated hourly rate, not on any form of contingency basis.
Therefore, payment of P&G’s fees and reimbursement of litigation
costs were on a dollar-for-dollar basis. P&G’s factual situation
is clearly distinguishable from that of the law firm in Boccardo.
Ultimately, the litigation costs in this case were not a burden
on P&G or a reduction of P&G’s fee income received from CSAA for
legal service rendered.
Petitioner advanced additional arguments with respect to the
reimbursed expenses and litigation costs. Petitioner argued that
respondent is estopped from denying the deductibility of the
litigation costs because petitioner relied on the contents of an
Internal Revenue Service publication entitled “Business Expenses
for 1988” (publication). The publication contains the following
statement, at 3:
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If you are a cash method taxpayer who pays an expense
and then recovers any part of the amount paid in the
same tax year, reduce your expense deduction by the
amount of the recovery. If you have recovery in a
later year, include the recovered amount in income.
* * *
Petitioner’s reliance on that publication is unwarranted
because the excerpt relied upon assumes that the expenditure is
deductible in the first instance. The material relied on by
petitioner does not address the critical preliminary question of
whether the costs advanced were loans or expenses. Reliance on
the Commissioner’s publication, in this instance, is misplaced
because it does not contain guidance on the question of which
costs, payments, or disbursements constitute a deductible
expense.4
Respondent, in the notice of deficiency, disallowed
petitioner’s claimed deduction of litigation costs for 1993.
Respondent also reversed petitioner’s 1993 income inclusion
attributable to reimbursement of litigation costs deducted in
prior years (including 1992). Finally, respondent determined
that section 481 applied, and so the reimbursement income
4
Assuming arguendo that the publication was applicable to
the question of whether or not advanced costs are deductible, the
statement relied on by petitioner is the statement of a legal
principle (i.e., Tax Benefit Rule). Because a necessary element
for estoppel is that there be reliance on a factual statement,
the circumstances here would not satisfy that necessary
prerequisite. See Estate of Emerson v. Commissioner, 67 T.C.
612, 617-618 (1977).
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reversed out by respondent was again included in 1993 income. On
brief, respondent contended that the section 481 adjustment was
necessary “to correct the distortion caused by the double
exclusion.” That is, petitioner deducted litigation costs for
1992 and, under respondent’s deficiency notice approach reversing
the reimbursement income, petitioner did not have to account for
the 1993 reimbursement of the previously deducted items.
Section 481(a) provides that where taxable income from any
year is computed under a method of accounting that is different
from the method used for the preceding year, then the computation
of the taxable income for the year of the change shall take into
account those adjustments that are determined to be necessary
solely by reason of the change in order to prevent duplications
and/or omissions. A section 481 change includes a change in the
overall plan or method of accounting for income or deductions. A
section 481 change also includes a change in the treatment of any
material item used in the overall plan. See secs. 1.481-1(a)(1),
1.446-1(e)(2)(ii)(a), Income Tax Regs. A material item is
defined as “any item which involves the proper time for the
inclusion of the item in income or the taking of a deduction.”
Sec. 1.446-1(e)(2)(ii)(a), Income Tax Regs. A “change in method
of accounting does not include adjustment of any item of income
or deduction which does not involve the proper time for the
inclusion of the item of income or the taking of a deduction.”
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Sec. 1.446-1(e)(2)(ii)(b), Income Tax Regs.; see also Copy Data,
Inc. v. Commissioner, 91 T.C. 26, 30-31 (1988); Schuster’s
Express, Inc. v. Commissioner, 66 T.C. 588, 597 (1976), affd.
without published opinion 562 F.2d 39 (2d Cir. 1977).
Here, petitioner claimed deductions for its clients’
litigation costs, which petitioner expected would be reimbursed.
The focus of respondent’s adjustment addressed whether petitioner
was entitled to deductions for those costs. Respondent did not
change the method of accounting by which petitioner reported a
particular item but instead determined that the item was not
deductible, ab initio. The result of petitioner’s deduction in
one year and inclusion in another may appear like a timing
question because it could result in increased deductions reducing
petitioner’s income in one year and petitioner’s reporting as
income any reimbursed deductions in a subsequent year. The
essence of respondent’s determination, however, was that
petitioner’s payments of litigation costs were loans to its
clients, so the deductions were not allowable and the
reimbursements were not includable in income.
Accordingly, section 481 is not applicable here, and
respondent’s attempt to obviate “the distortion caused by the
double exclusion” must fail. Respondent’s determination and
position on brief does not mention tax benefit principles that
might require petitioner to report, as income, the reimbursed
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litigation costs during 1993. By reversing petitioner’s
reporting of reimbursement income, respondent chose not to rely
on tax benefit principles. Respondent relied solely on section
481 to correct any improper prior year benefit and to cause the
inclusion in income of the reimbursed costs. Therefore,
petitioner is not entitled to deduct the litigation costs for its
1993 taxable year, and no section 481 adjustment is appropriate
for petitioner’s 1993 tax year.5
Finally, we note that respondent did not include in the
reversal of the reimbursements the aggregate of the $400 amounts
CSAA advanced to petitioner upon the beginning of each case.
Under petitioner’s approach the $400 amounts were included as
part of the reimbursement income reported. On brief, respondent
contended that petitioner had unrestricted use of the $400
amounts because they were first deposited in petitioner’s general
bank account and then transferred to a segregated account for
payment of litigation costs. Accordingly, respondent did not
reverse the $400 amounts out of income or include them in the
section 481 adjustment. Petitioner, however, has not
5
There is some question as to whether tax benefit
principles apply where a deduction was improperly or erroneously
taken (as it was in this case). We note, however, that an appeal
of this case would normally be to the Court of Appeals for the
Ninth Circuit, where tax benefit principles have been held to
apply concerning improper or erroneous deductions. See Unvert
v. Commissioner, 656 F.2d 483 (9th Cir. 1981), affg. 72 T.C. 807
(1979).
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specifically alleged error or countered, on brief, respondent’s
position with respect to respondent’s treatment of the $400
amounts. Accordingly, respondent’s decision not to reverse the
“$400 portion” of the reimbursement income is not in controversy,
and there is no need to consider that aspect of the
determination.
In addition to contesting the substance of respondent’s
determination, petitioner also contends that the amounts
disallowed by respondent are unreasonable and inaccurate. The
problem is generated by the fact that petitioner did not
specifically account for litigation costs in reporting its
income. Petitioner used a form of netting to arrive at the
amount of the claimed deduction. Petitioner’s approach is to
treat receipts and expenses as part of a “revolving pool into
which unsegregated receipts” were deposited and then used to pay
expenses. Respondent determined that $129,815 of petitioner’s
$358,092 in claimed deductions was not allowable by concluding,
in part, that reimbursements during the first 6 months of the
next fiscal year (ended May 1994) represented litigation costs
advanced by petitioner during the 1993 fiscal year. Petitioner
argues that respondent ignored the revolving pool concept and,
instead, calculated the disallowed portion of the deduction using
an analysis of individual cases pending in petitioner’s office.
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Respondent explained that his agent used a statistical
sampling technique to calculate the amount of the deduction to
disallow for the 1993 tax year. The agent analyzed a sampling of
cases to find the average time delay between expenditure and
reimbursement by calculating the average length of time a sample
case remained open. This was corroborated by reviewing the
frequency of bank deposits and comparing specific deposits to a
sampling of cases. By this type of methodology, respondent’s
agent estimated a 6-month period between expenditure and
reimbursement.
Although respondent’s determination involved estimates, it
is reasonably accurate under the circumstances because of
petitioner’s failure to maintain records that would identify the
amount of unreimbursed litigation costs for the fiscal year. In
that regard, petitioner bears the burden of showing that
respondent’s determination is in error. Petitioner has not
provided the Court with a method that is more reliable than
respondent’s. Petitioner’s failure to keep or present respondent
or the Court with adequate records showing the amounts involved
is of its own doing, and, accordingly, petitioner must bear those
consequences. See Silverton v. Commissioner, T.C. Memo. 1977-
198, affd. without published opinion 647 F.2d 172 (9th Cir.
1981). Accordingly, we sustain respondent’s determination as to
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the amount and characterization of the nondeductible advanced
litigation costs.
II. Net Operating Losses
FINDINGS OF FACT
P&G incurred a $3,382 net operating loss (NOL) for its 1990
fiscal year. For the 1991 fiscal year, P&G incurred a $277,478
NOL, and it did not carry either the 1990 or 1991 NOL back to
prior fiscal years. In addition, no election was made waiving
the NOL carryback with respect to prior years. On its Federal
income tax returns for the years ended May 31, 1992 and 1993, P&G
reported taxable income of $163,295 and $239,422, respectively,
without considering the NOL deductions. P&G carried the 1990 and
1991 NOL’s forward, applying them first to absorb fiscal year
1992 taxable income, and the NOL balance (deduction) was then
carried forward and applied to the 1993 fiscal year.
P&G sent a letter to the Internal Revenue Service Center in
Fresno, California, on August 14, 1990, containing the following
statement/question:
QUESTION TO IRS. We have a loss for the year
6/1/89 -- 5/31/90. Are we required to carry that loss
back to previous years, requiring amendment of previous
years’ returns, or may we just carry the loss forward
to future years and thus avoid the necessity of
amending prior returns? Thank you for your assistance.
P&G did not receive a response.
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Ultimately, respondent determined that the loss available
for use against the 1993 income should be reduced by the amount
of the loss which would have been absorbed if carried back to
pre-1990 fiscal years.
OPINION
Taxpayers are permitted to carry net operating losses from
one taxable year to another. See sec. 172(a). In general,
taxpayers who sustain NOL’s must first carry such losses back 3
years, and, if unabsorbed for the earlier years, then the losses
may be carried forward, for as long as 15 years. See sec.
172(b)(1)(A) and (2). A taxpayer, however, may elect to
relinquish the 3-year carryback period and simply carry a loss
forward. See sec. 172(b)(3). To make this election, the statute
expressly requires taxpayers to file an election relinquishing
the carryback period by the return due date, including any
extensions of time, for the taxable year in which the NOL was
first incurred. Once made, the election is irrevocable. The
statute directs the Secretary to prescribe the manner in which
taxpayers shall make the election. See id.
The Secretary promulgated the following requirements for
making the election:
[The election] shall be made by a statement attached to
the return (or amended return) for the taxable year.
The statement required * * * shall indicate the section
under which the election is being made and shall set
forth information to identify the election, the period
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for which it applies, and the taxpayer’s basis or
entitlement for making the election.
Sec. 301.9100-12T(d), Temporary Proced. & Admin. Regs., 57 Fed.
Reg. 43896 (Sept. 23, 1992) (redesignating sec. 7.0, Temporary
Income Tax Regs., 42 Fed. Reg. 1470 (Jan. 7, 1977)).
We have previously analyzed these statutory and regulatory
requirements under section 172 in Young v. Commissioner, 83 T.C.
831 (1984), affd. 783 F.2d 1201 (5th Cir. 1986). In Young, it
was held that in order substantially to comply with the election
regulations, “as an absolute minimum, the taxpayer must exhibit
in some manner, within the time prescribed by the statute, his
unequivocal agreement to accept both the benefits and burdens of
the tax treatment afforded by that section.” Id. at 839.
P&G’s August 14 letter falls far short of this minimum or
threshold requirement. First, the letter to the service center
was not attached to P&G’s return as required by the regulation.
Second, the letter does not manifest P&G’s agreement or intention
to make the election; it merely inquires whether such an election
can be made. In that regard, most of the NOL’s in question were
incurred during 1991, the year after P&G sent the letter of
inquiry to the service center. Under these circumstances, we
cannot find that P&G has complied with the regulatory
requirements, and we sustain respondent’s determination that
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P&G’s NOL should be reduced by the amounts that would have been
absorbed by the carryback of the losses to pre-loss years.6
III. Accuracy-Related Penalty Under Section 6662
Respondent also determined that petitioner was negligent and
liable for a penalty under section 6662(a) and (b)(1) for the
year at issue. Section 6662(a) and (b)(1) imposes an accuracy-
related penalty equal to 20 percent of an underpayment that is
attributable to negligence or disregard of rules or regulations.
Negligence has been defined as a “lack of due care or a
failure to do what a reasonable person would do under the
circumstances.” Leuhsler v. Commissioner, 963 F.2d 907, 910 (6th
Cir. 1992), affg. T.C. Memo. 1991-179. Respondent’s
determination of negligence is presumed correct, and petitioner
bears the burden of showing that respondent’s determination is
erroneous. See Rule 142(a). Therefore, petitioner must prove
that it was not negligent; i.e., that it made a reasonable
attempt to comply with the provisions of the Internal Revenue
Code and that it was not careless, reckless, or in intentional
disregard of rules or regulations. See sec. 6662(b) and (c). We
find that petitioner was negligent for deducting the advanced
litigation costs as ordinary and necessary business expenses and
6
To the extent we have not addressed certain other
arguments made by petitioner, we found them to be wholly without
merit.
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for disregarding the regulations concerning the treatment of
NOL’s.7
In deciding whether petitioner was negligent, we take into
account the legal background and years of legal experience
possessed by petitioner’s owner(s). See Glenn v. Commissioner,
T.C. Memo. 1995-399, affd. without published opinion 103 F.3d 129
(6th Cir. 1996). P&G and its officer(s) operated a law practice
and should have realized that the advances were to be fully
reimbursed and that they should have been treated as loans, not
expenses, for Federal income tax purposes. Ample case precedents
supporting our holding were extant at the time P&G claimed the
deductions. In addition, petitioner has not demonstrated that it
made a reasonable attempt to comply with the regulations
concerning the election to carry forward NOL’s. Under the
circumstances here, we cannot agree with petitioner, which
operates a law practice, that the inquiry made to respondent
7
Respondent also determined that petitioner was liable for
a sec. 6662(b)(2) penalty because its underpayment was
substantial. As a result of our holding with respect to the
negligence penalty, we need not address respondent’s alternative
penalty determination.
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about the election was sufficient to avoid the penalty for
negligence. Accordingly, petitioner is liable for the section
6662(a) penalty.
To reflect the foregoing,
Decision will be entered
under Rule 155.